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Wealth Conversion Efficiency Adjusted For Inflation

My wife and I registered online accounts with Social Security Administration so that thieves wouldn’t be able to register with our information stolen from Equifax. Social Security Administration recently sent us a reminder to review our Social Security statement. I took the opportunity to calculate our Wealth Conversion Efficiency ratio.

Wealth Conversion Efficiency ratio measures how efficient you are in converting your labor income to wealth. It’s based on the idea that you start out with nothing, or negative when you have student loans, then you earn income through your labor. After paying taxes and living expenses, you save some of your income. You grow your savings through investments. After some years you look back to see how much you have now relative to how much you earned through your labor all along. For instance if you have $1 million now and you earned total $2 million cumulatively, you converted 50% of what you earned to your wealth.

Just having a high income isn’t enough for a high Wealth Conversion Efficiency because taxes are high when you have a high income. Keeping your living expenses low relative to your income helps. Maxing out tax advantaged accounts helps. Investing well helps. Doing well in real estate or a business also helps. With good enough growth you can compensate for all the taxes you paid and all your living expenses in all these years since the very beginning.

Your Social Security statement is a good source for doing this calculation. Because there’s no earnings cap in Medicare tax since 1994 (see comment #4 from Paul below), the column “Your Taxed Medicare Earnings” gives you a complete history of your labor income since 1994. You can easily add those up and compare your current net worth against the total.

However, just adding up the raw numbers doesn’t take inflation into consideration. The $20,000 you earned years ago is worth a lot more today. We need to apply an inflation factor to each year’s earnings in the past. So I made a spreadsheet for it. You just enter the historical earnings from your Social Security statement and it will automatically adjust your earnings for inflation. If you worked before 1994 and you earned more than the taxed Medicare earnings back then, please replace the historical earnings before 1994 with your actual earnings.

Some types of income are still not reflected in the taxed Medicare earnings. Your 401k/403b employer match or employer contributions are not included. You can add them back in. If you are self-employed taxed as an S-Corp, you should add your S-Corp distributions. If you received gifts or inheritance, add them in the year you received them.

If you kept track of your net worth at the end of each year, you can enter them and see how your Wealth Conversion Efficiency progressed. It goes up over time because your investments typically grow faster than inflation. Given enough time, good savings rate, and good investment returns, someone can show a Wealth Conversion Efficiency of 100% or higher.

For the two of us, our Wealth Conversion Efficiency ratio stands at 60% today. After paying taxes and living expenses and investing the rest, we kept 60% of what we earned so far after adjusting for inflation. A strong stock market in recent years helped. That number was a lot lower in 2008.

You can download a copy of the spreadsheet, enter your earnings and net worth numbers in private and see how well you did. I like this metric because it incorporates everything: savings rate, investment returns, luck, and time. Just based on a hunch, I think good benchmark numbers would look like these:

Age

Wealth Conversion Efficiency

30

30%

40

40%

50

60%

60

80%

65

100%

I created an anonymous poll with just two questions: your age and your inflation-adjusted wealth conversion efficiency. If enough people answer the poll, I will publish a curve with the averages.

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what did you mean by “registered online accounts with Social Security Administration so that thieves wouldn’t be able to register with our information stolen from Equifax”
others might want to do it too

I tried to create my account online, but the website said that I have to call in and speak to a Customer Service representative. After waiting on the phone, I talked to one of the reps and she informed that I couldn’t create an account online because my account was frozen. The only way to create your account is to stop by a Social Security office and obtain an Access Code.

Harry, The Medicare numbers before 1994 do not reflect total earnings. 1990 and before, they had the same cut off as the SS numbers. 1991 through 1993, there was a higher Medicare cut off, but there was still a cut off. See:http://www.milefoot.com/math/businessmath/taxes/fica.htm

I am having some other problems with the spreadsheet, but I thought I should mention this first.

Thank you for that info. I didn’t make anywhere close to the Social Security limit before 1994. I will add a note to the post. I replaced the spreadsheet link originally on Zoho with one now hosted on Microsoft Office Online.

First off, thank you Harry for getting us to look at things a bit differently. What follows is not intended as criticism. Just things I encountered when poking into the details of the calculations.

Another way to calculate adjusted earnings is to use the wage-indexed earnings that appear as a column on page 4 of the output (Wage-indexed Formula) when running the SSA’s calculator (AnyPIA32.exe). The SSA uses the annual average wage indices for the adjustment, rather than the CPI-U, so I’m not sure how different the results will be (guess I could cut and paste to find that out!). I just ran the numbers, and the ratio of CPI-U-indexed to AWI-indexed for my wage history is 0.962. This ratio will vary depending upon the length of one’s history, and the earnings distribution over time.

Perhaps some non-wage, but non-investment income should be included when assessing one’s efficiency–patent royalties, gas well royalties, lottery and gambling winnings come to mind. Then there is the question about whether to include inherited assets anywhere.

Seems like the End of Year Net Worth needs to be scaled by an inflation factor, too. For example, if we look back at someone who had no debt or assets and who saved 100% of their earnings during the first year that they worked, they would have had an End of Year Net Worth that was just equal to their unadjusted earnings. That would be less than their inflation adjusted earnings, so they wouldn’t get credit for their 100% efficiency. Probably just use the same CPI-U ratio as is applied to earnings for the year.

The CPI lookup table is on the ‘helper’ tab. If you’d like to adjust with a different index series, such as the Social Security wage index, or a straight increase of say 5%/year, just paste in the numbers for a new series.

Inheritance or startup capital should be included in the year of receipt. If I started out with the family oil well that paid me a royalty I should include the value of the well in year one.

The net worth numbers are as of that year. There’s no adjustment in year one. If someone didn’t pay any taxes and didn’t spend anything on living expenses in year one, the efficiency number would be 100%, give-or-take intra-year investment gains or losses.

See reply to #5. All your financial accounts, value of your small business if you sell it, value of your home and rental real estate minus mortgage minus selling commission. Anything of value if you sell them, except I don’t include personal possessions.

Great article. Since NW = A – L, it seems we should include the NPV of guaranteed income streams. For example, wouldn’t I calculate the NPV of my pensions & include that in assets? In fact, wouldn’t I do the same for SS; especially considering that many of us have likely contributed to (‘invested in’) these guaranteed income streams.

If you include pension as assets you also have to include the pension contribution made by your employer and you as income each year. Social Security isn’t assets. The Supreme Court ruled in the 1960s that no one has a legally guaranteed right to it. You paid taxes to support the seniors at the time in the same way you paid taxes to pay for roads, defense, schools, and everything. You weren’t paying for your own benefits.

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